It was supposed to be easy

One client of Scott Hanson, co-head of Hanson McClain in Sacramento, Calif., had everything mapped out to take full advantage of the booming California real estate market. She would sell her house in the Sacramento area for a bundle, move to a quiet part of Nevada and buy a cheaper house — and fund her nest egg with the leftover money.

But something happened along the way: The California real estate market began cooling. The client put her house on the market for $725,000 about a year ago, but found no buyers. She finally decided to cut the price. Still no buyers. She cut the price again, and then a third time — the house is currently listed for $640,000. “It still hasn't sold,” Hanson says. The client is now in a serious bind — either she'll have to sell the house at a vastly reduced price that will barely buy an adequate home out of state and have nothing left for investing, or she'll have to stay put in the hope that home prices move upward again soon. Either way, she now realizes she has far less money for retirement than she imagined.

On the Edge

Financial advisors say this no-win situation is becoming more and more commonplace, particularly among clients who are nearing retirement and are banking on the value of their house to be the centerpiece of their retirement strategy. That bet could prove disastrous in the face of falling property values. The real estate boom of the past decade — in which property values (especially on the West and East coasts) soared — U.S. property values rose by about 50 percent on average from 2001 to 2005, according to the National Association of Realtors — and low interest rates spurred homebuying, looks to be winding down, leaving a host of potential retirees who believe, because they include the alleged value of their home in their net worth, that they are far richer than they actually are

“It's the people whose financial plans are right on the edge, those who haven't been the best savers, who are the ones most at risk,” says Sherman Doll, a principal with Capital Performance Advisors, in Walnut Creek, Calif. “It's because they keep in the back of their mind, ‘I have $800,000 in equity in the house.’ So mentally they start to slow down, and they feel wealthier than they really are. They're more likely to spend a little more, and save a little less, because they feel like they are sitting on a valuable asset.”

Big mistake. Advisors say that when a client is approaching retirement age, particularly one with inadequate savings and who lives in an area that has had rising real estate values, he needs to be told his house is not his retirement plan.

“It's not practical to use your home as part of your financial plan. I always leave it out when we do projections for clients,” Doll says. “Putting in the house in your projections is akin to cutting up the furniture to keep the fire going in the fireplace.”

Yet if you ask the average client whether it is a better value to invest in real estate than the stock market, odds are they'll choose real estate. It's understandable: In the past six years, the stock market has turned in a few dismal annual performances, while home values, particularly in hot areas like California, Florida and much of the Boston-to-Washington, D.C. corridor, have dramatically risen: Real home prices for the U.S. as a whole increased 52 percent between 1997 and 2004.

Yet in the long term, a home will likely return less than the most mediocre equity holding, as home price appreciation generally lags inflation, at best turning in 2 percent average annual returns. Robert Shiller, Stanley B. Resor Professor of Economics at Yale and author of Irrational Exuberance, says that because people sell their homes so rarely it creates a false sense of property-value inflation. For example, say a person in 1950 purchased a home for $16,000 and sold that house in 2004 for $190,000. A good investment, right? Not so fast. As Shiller notes, the consumer price index rose eightfold between 1948 and 2004, so the real increase in value of the house was only 48 percent, or less than 1 percent a year. Even if the house had sold for $360,000, it would have been only a real annual rate of increase of 2 percent. You can get better returns on a checking account.

“They don't do splits on houses,” Shiller says. “If you are investing for capital gains in your house, you shouldn't believe it is anything like the stock market in terms of returns.” Yet some recent surveys Shiller has conducted with homebuyers reflect a common belief that stock and real estate investments are roughly equal in terms of value, which is erroneous, he says.

What is even more troubling is that at the same time the housing boom has distorted clients' sense of asset values, Americans have greatly slowed down investing and saving. “Many times, the only thing of value that clients have is their house — they haven't saved anything,” says Libby Mihalka, at Altamont Capital Management, in Livermore, Calif. A recent survey by the Securities Industry Association found that 96 percent of the increase in the net worth of U.S. households from second-quarter 2004 to first-quarter 2006 has been from gains on assets, and almost half of that is due to real estate values. So had real estate values fallen instead of risen in that period, massive amounts of net worth would have been lost.

“People still think they can blithely spend in excess of their incomes and use their homes like piggy banks,” says Frank Fernandez, the SIA's chief economist. Most retirement account inflows that Fernandez has seen of late have been going into short-term investments, such as money markets, while at the same time, house price appreciation could likely be zero or negative in upcoming quarters.

So when you sit a client down for a get-real conversation about his retirement prospects and the client brings up his home value as an asset, there are a number of hard truths the client needs to understand, advisors say.

Homeownership has hidden expenses

Whatever gains a client might make by home price appreciation in a hot real estate market are often undermined by conveniently forgotten expenses, such as rising property taxes and general upkeep costs. And, of course, a person's house isn't traded continuously from 9:30 a.m. to 4 p.m.

Even during housing booms, many clients fail to realize that it won't be easy to downsize. Chances are, if your big house has gone up in value, so has the small one in your market.

Betting on real estate is like going to Las Vegas

One of Sherman Doll's clients is a dentist with a large amount of invested wealth. “Someone who didn't need to take any risks,” Doll says. A while ago, the client got a call from an acquaintance about a real estate venture in Florida where a developer was building beachfront condominiums. The pitch was that the condos, for which ground had yet to be broken, would sell at $200,000 more than the original purchase price. So a year ago the dentist paid $800,000 for a condo, and now, with the property about to be finished, “the line of potential buyers has completely dried up,” Doll says. “He had planned on flipping it — well, now he's going to be an owner. It will be a very distant vacation home for him.”

Instead, Doll tries to steer his clients to invest in a real estate investment trust, which is more diversified and liquid.

Home improvements are not investments

Another fallacy clients often believe is that if home prices are rising faster than the stock market, for example, it is better to take any spare capital and invest it into their own property, rather than investing it in equities, bonds or other alternatives. Hanson has had some clients who had $100,000 to invest and chose to use it to expand their house or build a swimming pool in their back yard. “The belief is that ‘Why do I need to save so much in my 401(k) when my house is making me so much money?’,” he says.

Rather than considering their house to be a better-performing bond portfolio, clients should instead consider it “a very large consumer durable,” Feiger says. “It's like a very expensive car. It has some investment value, but that is a lucky accident. If you wanted to retire two years ago and sold your house and moved to Texas, boy did you luck out. Because that wouldn't work now, and eight years ago it wouldn't have worked, and five years from now it won't work. Residential real estate is a lousy source of cash for retirement.”

Yet, for some clients home equity remains the only real asset they have, and that predicament could spur a massive increase in various types of home-equity lending. In particular, the reverse mortgage — in which a mortgage lender makes periodic payments to the borrower using the borrower's equity in the home as security — is growing in appeal as a sort of last-resort retirement income strategy.

Another of Hanson's clients, who had $600,000 in his IRA, told Hanson he wanted to get a reverse mortgage. Hanson counseled against it, but the client said, “If I have a reverse mortgage, I don't have to take out as much from my IRA, and I know worst case, I can live here [in my house] until my dying day.” Hanson, sensing the future, is making a bet of his own — he now owns 40 percent of a reverse mortgage lender.